Interest rates to rise in the U.S.?

Global credit markets seized up in the late summer and early fall of 2011, and the global economy weakened significantly.  Through the second half of 2011 central banks moved squarely back to easing, and then in late 2011 and now in early 2012 it looks like the easing has made liquidity more available and credit conditions have turned.

In turn, there are signs that the relaxing of those pressures is already flowing through to broader global conditions, with growth and markets beginning to improve.

From a monetarist perspective, the equilibrium levels of national income and wealth are a function of the quantity of money, broadly defined, while changes in the quantity of money, broadly-defined, are roughly equal to changes in the size of the banking system.

Seen from a monetary perspective, the Great Recession of 2007 – 2011 had three main causes.

First, there were losses on bank assets, which would have constrained the growth of capital across much of the industry whatever the regulatory situation, due to the American housing market reversal and the so-called “sub-prime crisis”.

Secondly, there was the related closure of the international inter-bank market in July/August 2007 which obliged banks that were net debtors to other banks to shrink their assets.

Thirdly, and now most significantly, there were new regulations including the setting of higher capital/asset ratios, restrictions on inter-bank funding exposures and similar.

These three developments taken together caused the growth rate of ‘broad money’, which had been typically in the double digits in 2006 and 2007 in the leading economies, to plunge to zero in late 2008, and to stay depressed in 2009 and 2010.

However, there is a cyclical nature to these things, and it was to be expected that sooner or later there would healing in the system, particularly after banks once more had adequate capital to extend credit.

In the USA, where the economic data have been consistently stronger of late, there are signs that the banking system is now much more healthy. Certainly some additional capital rebuilding may still be necessary, but critically banks are growing risk assets. Thus, in the six months to December loans and leases in bank credit, which broadly approximates to bank lending to the private sector, increased at an annualised rate of 5.0%.

This increased activity is assisting bank profitability, and retained profits are supporting balance sheets.

The consequence of the rebuild of bank profitability and balance sheets, and the improved availability of credit must be that sooner or later, assuming that the positive trends are maintained, there will be a return to significantly positive interest rates, and we should expect to see this in the US before the UK or Euroland.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla